Exam Prep: Liquidity Stress Testing - How Much is Enough?
Banking regulators seem to be increasingly focused on liquidity, or more appropriately stated, they seem to be increasingly focused on stressed liquidity. Stressed liquidity, of course, is when the balance sheet is stressed by an immediate decrease in deposits coupled with a reduction in the capacity to borrow. The concept of stressed liquidity was extremely important during the early years of the credit crisis beginning in 2007 and continuing until banks either failed or worked out their credit issues. This was followed by a “lull” in regulatory scrutiny, but recent increases in the ratio of loans-to-deposits have brought renewed interest in the concept.
There are three “stress scenarios” that are “triggered” by the loss of deposits:
- The first is a “Mild Stress Event” that merely reduces deposits by 5% over a period of a couple of weeks.
- The second is a “Moderate Stress event” that reduces deposits by 10% and ability to borrow over a three-month period.
- The third is a “Severe Stress Event” that reduces deposits by 20% and the ability to borrow over a one-year time frame.
The “Severe Stress Event” is the most scrutinized. At the end of the day (or the end of the exam) if the Cumulative Net Surplus in the 181-365 days period is NEGATIVE, or marginally positive, be prepared to produce your Contingency Funding Policy! Even if your numbers are solidly positive in the last time bucket, it is still imperative that this policy be updated, accurate, reasonable, comprehensive, and most importantly, an effective tool to provide the liquidity needed.